The Limits of The Limits of Arbitrage: Abstract

Review of Finance (2010) 14: 157–187
doi: 10.1093/rof/rfp018
Advance Access publication: 4 October 2009
The Limits of the Limits of Arbitrage

ALON BRAV1 , J.B. HEATON2 and SI LI3
1
Professor of Finance, Duke University Fuqua School of Business; 2 Partner, Bartlit Beck
Herman Palenchar & Scott LLP; 3 Assistant Professor of Finance, Wilfrid Laurier University
School of Business and Economics
Abstract. We test the limits of arbitrage argument for the survival of irrationality-induced financial
anomalies by sorting securities on their individual residual variability as a proxy for idiosyncratic
risk – a commonly asserted limit to arbitrage – and comparing the strength of anomalous returns
in low versus high residual variability portfolios. We find no support for the limits of arbitrage
argument to explain undervaluation anomalies (small value stocks, value stocks generally, recent
winners, and positive earnings surprises) but strong support for the limits of arbitrage argument to
explain overvaluation anomalies (small growth stocks, growth stocks generally, recent losers, and
negative earnings surprises). Other tests also fail to support the limits of arbitrage argument for the
survival of overvaluation anomalies and suggest that at least some of the factor premiums for size,
book-to-market, and momentum are unrelated to irrationality protected by limits to arbitrage.
JEL Classification: G11, G12, G14
1. Introduction
Empirical asset pricing tests of the predictions of the Sharpe-Lintner CAPM often
result in model falsification. Small stocks earn returns that are higher than predicted
(see Banz, 1981), as do recent winners (see, e.g., Chan et al., 1996), value stocks
(see, e.g., Lakonishok et al., 1994), and stocks of companies with positive earnings
surprises (see, e.g., Ball and Brown, 1968; Bernard and Thomas, 1990). Growth
We thank Ray Ball, Nick Barberis, Zahi Ben-David, Peter Bossaerts (the editor), Michael Brandt,
Markus Brunnermeier, George Constantinides, Campbell Harvey, Dong Hong, Ron Kaniel, Reuven
Lehavy, Jon Lewellen, Mark Loewenstein (a discussant), Toby Moskowitz, Doron Nissim, Per Olsson,
Matthew Rothman, Darren Roulstone, Ronnie Sadka, Richard Thaler, Mohan Venkatachalam, Mitch
Warachka, two anonymous referees, and seminar participants at the Seventh Maryland Finance
Symposium, the Securities and Exchange Commission Office of Economic Analysis, Duke University,
Hebrew University, Interdisciplinary Center, Herzlyia, Israel, Northwestern University and Vanderbilt
University for helpful comments. Please address correspondence to Brav at Fuqua School of Business,
Duke University, Box 90120, Durham, North Carolina 27708–0120, email: brav@duke.edu. Heaton
acknowledges that the opinions expressed here are his own, and do not reflect the position of Bartlit
Beck Herman Palenchar & Scott LLP or its attorneys. Li acknowledges financial support from the
Social Sciences and Humanities Research Council of Canada.

C The Authors 2009. Published by Oxford University Press [on behalf of the European Finance Association].
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158 A. BRAV ET AL.
stocks, recent losers, and negative earnings surprises earn returns that are lower
than predicted (see, e.g., Ritter, 1991; Barberis and Huang, 2008; Ball and Brown,
1968; Bernard and Thomas, 1990; Chan et al., 1996).
Researchers in behavioral finance argue that asset pricing anomalies result
from the influence of unmodeled irrational behavior on security prices (see, for
example, the extended discussion in Barberis and Thaler (2003) of the above anoma-
lies). The behavioral claim is controversial. First, rational behavior is just one of
several assumptions used to derive the tested asset pricing models. Model falsifi-
cation might result from the failure of an assumption other than the assumption of
rationality (see Cross, 1982; Lowenstein and Willard, 2006; Fama, 1991). Second,
the behavioral claim implies that rational arbitrageurs cannot exploit the irrational
investors and drive irrationality-induced price deviations to zero (see Friedman,
1953; Fama, 1965) or near-zero (see Grossman and Stiglitz, 1980) levels. We call
this the “arbitrage objection.”
To rebut the arbitrage objection, some researchers have argued that arbitrage is
more difficult than recognized by those offering the arbitrage objection. Barberis
and Thaler (2003) survey the literature and identify three sources of limits to
arbitrage: idiosyncratic risk, noise trader momentum risk, and implementation costs.
Idiosyncratic risk is proposed as a limit to arbitrage in several papers.1 In their
paper, “The Limits of Arbitrage,” Shleifer and Vishny (1997) explain their model
as follows:
To specialized arbitrageurs, both systematic and idiosyncratic volatility matters. In fact, id-
iosyncratic volatility probably matters more, since it cannot be hedged and arbitrageurs are
not diversified. . . . In our model . . . stocks are not rationally priced, and idiosyncratic risk
deters arbitrage. . . . For a given noise trading process, volatile securities will exhibit greater
mispricing and a higher average return to arbitrage.
Barberis and Thaler (2003) explain idiosyncratic risk as a deterrent to arbi-

trage by using the example of a hypothetically undervalued share of Ford Motor
Company:
The most obvious risk an arbitrageur faces if he buys Ford’s stock at [the undervalued price of]
$15 is that a piece of bad news about Ford’s fundamental value causes the stock to fall further,
leading to losses . . . Shorting General Motors protects the arbitrageur somewhat from adverse
news about the car industry as a whole, but still leaves him vulnerable to news that is specific
to Ford – news about defective tires, say.
Noise trader momentum risk, according to Barberis and Thaler (2003), is the risk
that irrational beliefs get worse in the direction already distorting prices:
Noise trader risk . . . is the risk that the mispricing being exploited by the arbitrageur worsens in
the short run. Even if General Motors is a perfect substitute for Ford, the arbitrageur still faces
1
See also Pontiff (1996); Ali et al. (2003); Mendenhall (2004); Wurgler and Zhuravskaya (2002);
Mashruwala et al. (2006); and Pontiff (2006).
THE LIMITS OF THE LIMITS OF ARBITRAGE 159
the risk that the pessimistic investors causing Ford to be undervalued in the first place become
even more pessimistic, lower its price even further. Once one has granted the possibility that
a security’s price can be different from its fundamental value, then one must also grant the
possibility that future price movements will increase the divergence.
Finally, Barberis and Thaler (2003) posit that “[w]ell understood transaction costs
such as commissions, bid-ask spreads and price impact can make it less attractive
to exploit a mispricing.”
In this paper, we report the results of a set of tests designed to test the limits of ar-
bitrage argument. Under the hypothesis that greater idiosyncratic volatility protects
the existence of greater levels of mispricing, our first set of tests sorts securities on
the size of their residual variability from the Fama and French four-factor model
(as a measure of idiosyncratic risk) and ask whether financial anomalies increase
in magnitude with the amount of residual variability. Under the hypothesis that
momentum in the same direction protects greater levels of mispricing, in our sec-
ond set of tests we form portfolios of value stocks – which, according to some
researchers, earn abnormal positive returns because irrational investors extrapolate
past bad performance into the future (see, e.g., Lakonishok et al., 1994) – and
sort them into those exhibiting negative momentum and those exhibiting positive
momentum, testing the prediction that arbitrage against loser-value stocks is riskier
and thus should deter arbitrage and allow for the survival of higher abnormal returns
to value stocks.
Our first set of tests reject the limits of arbitrage argument for positive return
anomalies – small value stocks, value stocks generally, recent winners, and posi-
tive earnings surprises – since in each case we do not find the relation predicted
by the limits of arbitrage argument. Instead, these anomalies are stronger when
idiosyncratic risk is low. These results are robust to alternative specifications of
idiosyncratic risks and transactions costs. In fact, the high positive correlations be-
tween total and residual volatility and other generally accepted measures of limits
of arbitrage like the extent of institutional holding, analyst coverage, and stock price
level suggest that it is unlikely that any alternative measures of idiosyncratic risk
or transactions costs could change our inferences. To reverse our inferences, alter-
native measures would have to be both different and move in the opposite direction
from current proxies. It is difficult to imagine such alternative measures retaining
plausible interpretation as limits of arbitrage. The evidence is not consistent with
the limits of arbitrage argument for the survival of irrationality-induced underval-
uation of small value stocks, value stocks generally, recent winners, and positive
earnings surprises. However, our first set of tests does strongly support the limits of
arbitrage argument for the abnormal returns to small growth stocks, growth stocks
generally, recent losers, and negative earnings surprises. Negative returns to these
anomalies occur only among stocks with high residual variability from the Fama
and French four-factor model.
160 A. BRAV ET AL.
Our second set of tests rejects the limits of arbitrage argument for both under-
valuation and overvaluation anomalies. In those tests we ask whether noise trader
momentum risk might allow more mispricing of value and growth firms when re-
cent returns have been bad (for value firms) or good (for growth firms). The idea
is simple: if value firms are mispriced due to excessive extrapolation of bad perfor-
mance, those firms that have had very recent poor performance have momentum
in the direction of the mispricing and should be riskier to bet against. The same
holds true for overpriced growth firms that have been doing well recently. But we
find the opposite to be true: value firms that are recent losers have lower returns
than value firms that are recent winners, and growth firms that are recent losers
do worse than growth firms that are recent winners. Both results are inconsistent
with the behavioral null provided by the noise trader momentum risk version of the
limits of arbitrage argument.
Finally, we ask whether there is a factor premium for size, book-to-market, and
momentum in portfolios comprised of the lowest residual variability stocks. The
lowest residual variability stocks not only have low idiosyncratic risk but also
have high median prices, high institutional holdings, a larger number of analysts,
considerable liquidity, high divided yields, and comprise a large part of the market
capitalization of the entire market. It is difficult to argue that limits of arbitrage are
meaningful in these stocks. If the factor premiums for size, book-to-market, and
momentum were driven entirely by irrationality then we would expect very little
covariation with these factors in the lowest residual variability portfolios. Instead,
we find a strong role for these factors in explaining the returns to zero cost portfolios
of the lowest residual variability stocks.
The rest of the paper is organized as follows. Section 2 discusses earlier attempts
to test the limits of arbitrage argument. We present the data and methodology in
Section 3. In Section 4, we report the first set of results linking limits to arbitrage and
average returns to size, value, momentum, and earnings surprise based strategies.
Section 5 provides an additional test based on the profitability of investing in
both value and momentum strategies. In Section 6 we ask whether size, value and
momentum premia exist even in low limits to arbitrage environment. We conclude
the paper in Section 7.
2. Comparison to Studies Finding Support for Limits of Arbitrage

Explanations
We reach opposite conclusions than other recent papers that purport to confirm
limits of arbitrage explanations of financial anomalies that we reject here, in-
cluding Ali et al. (2003), Zhang (2006), and Mendenhall (2004). We find that
prior studies, by equal-weighting rather than value-weighting returns, by failing to
consider separately undervaluation and overvaluation anomalies, and by using re-

search designs with non-implementable trading strategies (high frequency trading
of very small cap securities and event-time analysis), are not robust to stronger
research design. At the same time, the poor performance of small growth stocks
– the dominant overvaluation anomaly – is so strong in high limits to arbitrage
environments that tests of whether that poor performance is confined to high limits
to arbitrage environments are not particularly sensitive to research methodology.
Ali et al. (2003) argue that the spread in returns between value and growth firms
is cross-sectionally correlated with proxies for arbitrage costs such as idiosyncratic
risk and conclude that the book-to-market (i.e., value versus growth) effect is likely
to be due to market mispricing. Specifically, they rely on the difference between
value and growth size-adjusted buy and hold returns to show that this difference is
larger when limits to arbitrage are higher. However, their results are driven entirely
by the presence of overvaluation (i.e., the underperformance of growth stocks) in
high limits to arbitrage environments, not by the presence of undervaluation (i.e. the
overperformance of value stocks). That is, by measuring only the difference between
value and growth returns, they miss the fact that their result is explained entirely by
the underperformance of small growth firms, not by relative good performance of
value stocks in high limits to arbitrage environments. This will become clear below
when we present results separately for value and growth stocks.
Another study, Zhang (2006), focuses on the interaction between profits to mo-
mentum strategies and measures of information ambiguity such as firm size, age,
analyst coverage, dispersion in analyst forecasts, cash flow volatility, and stock
volatility measured as the standard deviation of weekly excess returns relative to
the market portfolio measured over the one-year pre formation period. Zhang finds
that loser (winner) stocks tend to earn larger negative (positive) abnormal returns in
high ambiguity environments that are reasonably interpreted as high limits to arbi-
trage environments. His results for losers are consistent with ours – losers perform
poorly only in high limits to arbitrage environments – but his results for recent win-
ners are inconsistent with both the finding in this paper and those reported in Ang
et al. (2006). We find that Zhang’s findings hinges primarily on equal weighting
his constituent stocks (giving dramatically more weight to the tiniest and relatively
illiquid firms than their value-weighted counterparts) and his high frequency rebal-
ancing of such firms that is unlikely to reflect real world trading opportunities. To
the extent that equal-weighting can be defended as a way to put more focus on small
firms where mispricing might be likely, it still is important to recognize the effect
that very small firms with their considerable market microstructure challenges have
on measures of abnormal return. In any case, Zhang’s results are not robust to value
weighting.
Mendenhall (2004) examines the link between arbitrage risk and the post-
earnings announcement drift. He finds that both positive and negative drift increase
162 A. BRAV ET AL.
in absolute value as one holds portfolios of high residual variability stocks, a proxy
for limits to arbitrage. His evidence is inconsistent with our finding that the pos-
itive drift is actually confined to low limit to arbitrage environments. However,
while we design our tests around a simple passive and implementable calendar
time trading strategy with appropriate adjustment for common risk factors in re-
turns, Mendenhall’s design considers only non-implementable event-time analysis,
in which returns are equally weighted and risk or factor adjustment is made only
with respect to size matched portfolios.2 Of course, one might argue that an anomaly
identified by a non-implementable trading strategy necessarily invokes the limits of
arbitrage argument because a trading strategy that is non-implementable is necessar-
ily a limit to arbitrage. This calls into question whether the anomaly is economically
interesting since it does not exist in a tradeable form. Moreover, Mendenhall uses
a market model to form estimates of residual volatility, leaving common factors in
returns due to size, book to market and momentum, which are therefore included in
his measure of residual variability. Sorting on his market model residual volatility
results in a sort on these firm characteristics. As a result, his control for size related
differences in average returns is incomplete.
3. Data and Implementation
We obtain stock returns from the Center for Research in Security Prices for all firms
traded on the NYSE, AMEX, and NASDAQ, subject to the restriction that they
have CRSP common share codes equal to 10 or 11, from July 1958 to December
2007. Accounting data is obtained from Compustat. We measure the magnitude
of specific anomalies with average excess returns, alpha estimates, and Sharpe
Ratios (annualized excess returns per unit of standard deviation) for small stocks
(including small growth stocks and small value stocks), recent winner stocks, recent
2
The use of calendar-time regressions to measure abnormal performance has been questioned by
Loughran and Ritter (2000). They argue that the implementation of calendar-time regressions can
result in low power to reject a null model in tests of market efficiency. One concern is the choice of
equal versus value weighting of portfolio returns. If mispricing is likely to occur in hard to arbitrage
small firms then a weighting scheme that tilts away from these firms will result in low power. We share
this concern and thus report, for each undervaluation and overvaluation anomaly, tests that restrict the
sample to the subset of small firms. Loughran and Ritter (2000) also argue that benchmark factors
might be “contaminated” by the test assets that are to be priced. For example, the inclusion of the
book to market factor, HML, in the Fama and French three-factor model may lead to low power since
many of the issuing firms that they try to price are included in this factor. It is unclear, however, why
this concern applies in the context of our tests. As we show in Section II, the calendar-time setup
affords the power needed to support our conclusions. At any rate, our conclusions do not rest on
the three or four -factor models as our tests are benchmarked purposely against the CAPM precisely
because we want to measure abnormal returns against a null model that behavioral finance has no
objections to.
loser stocks, value stocks, growth stocks, and stocks subject to both positive and
negative extreme earnings surprises. For each characteristic-based anomaly (e.g.,
small stocks) we estimate, beginning in July of 1963, for each firm, a four-factor
regression using monthly return data from the preceding five years. We use a
minimum of 36 monthly returns to estimate the regressions. Firms are allocated
to quartile portfolios based on the magnitude of the estimated residual standard
deviation and we value weight firm returns for the ensuing three months. We
require a minimum of 50 firms in each portfolio. This portfolio formation is
repeated quarterly through December 2007.3 We estimate idiosyncratic risk from
a four-factor asset-pricing model including the Fama and French RMRF, SMB,
and HML factors and a momentum factor, MOM. We obtain these factor returns
and monthly risk-free rates (which we use to calculate excess returns) from Ken
French’s web site at Dartmouth College.4
4. Results for Characteristic-Based Anomalies
4.1 SMALL STOCKS
Panel A of Table I presents results for small stocks. Small stocks are those traded on
NYSE, AMEX, and NASDAQ with CRSP common share codes 10 or 11 that fall in
the bottom size quintile using NYSE market capitalization quintile breakpoints. We
allocate these stocks into quartile sorts based on the magnitude of their estimated
residual variability. Q1-Low (Q4-High) is a portfolio holding firms with lowest
(highest) estimated residual variability.
An immediately interesting result – one that appears throughout our tests – is the
apparent existence of large amounts of covariation among stocks with high residual
variability. The R-squared of the portfolio of the highest residual variability stocks
falls dramatically to 73.51 from 88.06 for the lowest residual variability stocks.
It is worthwhile noting that this covariation, if it is not hedgeable, makes betting
against high residual variability stocks even riskier since the idiosyncratic risk will
not even disappear in large portfolios of potentially mispriced securities.
High returns to small stocks occur only in the lowest idiosyncratic risk quartiles,
and not at all in the highest quartile, the opposite of the relation predicted by the
limits of arbitrage argument. When we perform CAPM regressions on these port-
folio returns, there are no anomalous returns relative to the CAPM for small stocks
in high idiosyncratic risk portfolios. The CAPM prices the portfolio of the highest
residual variability stocks with an insignificant negative alpha of 34 basis points
3
None of our conclusions change if portfolios are rebalanced every six or twelve months, although
the overall profitability of the momentum strategy (both winners and losers) declines.
4
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
164 A. BRAV ET AL.
Table I. Post-formation results for the “small” stock subsample: 1963–2007

The universe is all firms traded on NYSE, AMEX, and NASDAQ with CRSP common share codes
10 or 11. We focus on firms in the smallest size quintile. Firm size is the market capitalization in the
month of July preceding portfolio formation. Beginning in July of 1963 we estimate, for each firm, a
four-factor regression using monthly return data from the preceding five years. We require a minimum
of 36 monthly returns. The four factors are the Fama and French RMRF, SMB, HML factors including
a momentum factor, MOM. The four factors and the size and book-to-market quintile breakpoints
are obtained from Ken French’s web site. Firms are allocated into quartiles based on the regression
residual standard deviations. We calculate portfolio value weight returns for the ensuing three months
requiring a minimum of 50 firms in each portfolio. The sorting procedure is repeated quarterly
through October 2007 and we report summary statistics for the period ending in December 2007. The
column ‘Q1-Low’ (‘Q4-High’) refers to a portfolio holding the securities with the lowest (highest)
residual standard deviation. The column ‘ALL’ refers to the portfolio holding all small stocks.
Panel A provides the resulting portfolio return characteristics including CAPM alpha, four-factor
factor loadings and alpha, regression R2, and number of monthly observations. The remaining rows
provide information on firm characteristics allocated to the portfolios in the pre-formation period.
Median stock price level is calculated as follows. For each formation quarter, we record the median
stock price of firms allocated to a given portfolio as of the preceding month and report the average
across the full sample period. Institutional holding is the percent of shares held by institutions
calculated by averaging the percent shares held in the pre-formation month. Institutional holdings
are from Thomson Financial’s CDA/Spectrum Institutional (13f) Holdings data. Number of analysts
following a firm is obtained from IBES. We calculate the average number of analysts per firm in the
quarter post-formation and then average across firms and across time. Amihud measure is calculated
as the ratio of the absolute daily return to daily dollar volume averaged over a month. We average this
measure across firms allocated to a portfolio. Percent dollar volume is calculated as follows. We obtain
the sum of dollar volume traded of all firms in a given portfolio and calculate the fraction relative
to the total dollar volume across all portfolios. Campbell IV is an estimate of stock idiosyncratic
volatility calculated as in Campbell et al. (2001). We report the average volatility within a portfolio.
Dividend yield is calculated as the difference between the buy and hold return including dividends in
the 12 months post-formation and the buy and hold return, over the same period, excluding dividends.
We then average these yields across firms in a given portfolio and then across time. Percent of Market
Cap is the time series average of the pre formation weight of wealth traded in each portfolio relative
to the CRSP universe. In Panels B (C) we further narrow the universe to small growth (value) firms,
those in the smallest size quintile and lowest (highest) book-to-market quintile. Book-to market is
the ratio of fiscal year-end book equity plus balance sheet deferred taxes in the year preceding the
formation year to market equity in December preceding the formation period.
Q1-Low Q2 Q3 Q4-High All
Panel A: Small Stock Universe

Average Excess Return 0.90 0.96 0.92 0.38 0.84
Standard Deviation 4.36 6.21 7.69 9.10 6.26
Sharpe Ratio 0.72 0.54 0.41 0.15 0.47
CAPM Alpha 0.54 0.43 0.26 −0.34 0.31
T-stat Alpha 4.32 2.67 1.25 −1.32 1.89
Four-Factor Alpha 0.19 0.02 −0.12 −0.59 −0.09
T-stat Alpha 2.59 0.22 −0.78 −2.70 −0.86
Four-Factor Market Beta 0.77 1.08 1.22 1.30 1.05
Table I. Continued
Four-Factor SMB Loading 0.69 1.01 1.16 1.31 1.00

Four-Factor HML Loading 0.58 0.57 0.34 0.14 0.44
Four-Factor MOM Loading −0.05 0.01 0.10 0.12 0.08
Four-Factor R2 88.06 90.67 81.93 73.51 87.22
Monthly Observations 533 533 520 524 534
Median Price 15.17 9.21 6.15 3.93 8.02
Institutional Holding 20.59 24.09 18.60 11.18 18.72
Number of Analysts 2.19 2.56 2.64 2.21 2.43
Amihud Measure 4.74 9.29 17.14 34.98 16.19
Percent Dollar Volume 16.76 27.17 29.41 26.66 100.00
Campbell IV 10.25 14.75 18.90 24.38 16.97
Dividend Yield 3.74 1.71 0.88 0.46 1.74
Percent of Market Cap 0.88 0.74 0.59 0.42 2.63
Panel B: Small Growth Universe
Average Excess Return 0.77 0.66 0.21 −0.68 0.48
Sharpe Ratio 0.43 0.26 0.08 −0.23 0.20
CAPM Alpha 0.11 −0.21 −0.71 −1.62 −0.26
T-stat Alpha 0.57 −0.71 −2.23 −4.41 −1.11
Four-Factor Alpha −0.09 −0.37 −0.85 −1.52 −0.46
T-stat Alpha −0.55 −1.31 −3.38 −3.77 −2.75
Four-Factor HML Loading 0.09 −0.08 −0.18 −0.23 −0.06
Four-Factor MOM Loading 0.15 0.22 0.27 0.02 0.14
Four-Factor R2 74.68 63.54 67.85 60.07 76.51
Median Price 12.60 8.02 5.75 3.97 6.97
Amihud Measure 3.82 6.78 9.06 17.72 9.14
Campbell IV 13.92 18.07 20.76 24.48 19.21
Dividend Yield 1.35 0.57 0.39 0.18 0.65
Panel C: Small Value Universe
Sharpe Ratio 0.84 0.51 0.51 0.52 0.67
CAPM Alpha 0.78 0.41 0.48 0.58 0.66
T-stat Alpha 4.95 2.06 2.11 2.21 3.97
Four-Factor Alpha 0.32 −0.06 0.01 0.11 0.16
T-stat Alpha 3.60 −0.50 0.05 0.55 1.84
Four-Factor MOM Loading −0.06 −0.06 −0.03 0.01 −0.03
Four-Factor R2 87.20 86.75 81.86 70.33 89.42
166 A. BRAV ET AL.
Table I. Continued

Median Price 13.22 8.00 5.65 3.82 6.99
Amihud Measure 6.31 11.27 22.76 55.57 23.54
Campbell IV 10.56 14.61 18.79 24.73 17.08
Dividend Yield 3.66 1.80 1.10 0.66 1.85
per month. The lowest idiosyncratic risk portfolio, however, earns a statistically
significant positive 54 basis points per month. The same result hold for returns
relative to the Fama and French four-factor model. The anomalous returns to the
smallest stocks are statistically significant and positive for the lowest idiosyncratic
risk portfolio (0.19; t-statistic of 2.59) while the highest idiosyncratic risk quartile
earns statistically significant negative returns (−0.59; t-statistic −2.70).
The annualized Sharpe Ratio increases monotonically from the highest idiosyn-
cratic risk quartile to the lowest, contrary to the predictions of the limits of arbitrage
argument. The Sharpe Ratio of the lowest idiosyncratic risk quartile is 0.72, while
the Sharpe Ratio of the highest idiosyncratic risk quartile is 0.15. The difference
between these two Sharpe Ratios is both a return and a standard deviation effect.
The highest idiosyncratic risk portfolio has the lowest portfolio average monthly
excess return of 0.38 and the highest portfolio monthly standard deviation of 9.10.
Portfolio standard deviations decrease monotonically from the highest idiosyncratic
risk quartile to the lowest. Since we form these portfolios using individual security
residual variance, this tells us that high residual variance securities tend also to have
exposures to common factors in returns that do not wash out in large portfolios.
That is, firms with high residual variance tend to share high common variation in
return. This is apparent from the pattern of four factor loadings. Market loadings
increase monotonically from 0.77 in the lowest idiosyncratic risk quartile to 1.30 in
the highest idiosyncratic risk quartile. SMB loadings increase monotonically from
0.69 to 1.31 from the lowest to the highest idiosyncratic risk quartile while the
loadings on HML decrease monotonically from 0.58 to 0.14. Loadings on the mo-
mentum factor exhibit a small increase from the lowest to the highest idiosyncratic
risk quartiles. This pattern is apparent in all of our results: high residual variability
securities have high market betas and high SMB loadings.
We next explore the evidence with respect to stock price level, institutional
ownership, analyst following, liquidity, and market capitalization. ‘Median stock
price level’ provides information on the price level of securities allocated to the
portfolios. Each quarter, we record the median stock price of firms allocated to a
given portfolio as of the preceding month and report the average across the full
sample period. For small stocks, median prices fall from the lowest to the highest
idiosyncratic risk quartiles. The median price of the lowest idiosyncratic risk quartile
is $15.17, decreasing to $3.93 in the highest idiosyncratic risk quartile. We obtain
institutional holdings from Thomson Financial’s CDA/Spectrum Institutional (13f)
Holdings data. ‘Institutional Holding’ is the percent of shares held by institutions
calculated by averaging the percent shares held in the pre-formation month and
then averaged across time. For small stocks, institutional holding in the lowest
idiosyncratic risk quartile is nearly twice that in the high limits portfolio. Number
of analysts following a firm is obtained from IBES. We calculate the average
number of analysts per firm in the quarter post-formation and then average across
firms and across time. For small stocks, there is no clear pattern in the number of
analysts.
Illiquid stocks may be harder to arbitrage. We calculate two measures that proxy
for illiquidity. The first, ‘Percent dollar volume’, is calculated by first obtaining the
sum of dollar volume traded of all firms in a given portfolio. Then, for each quartile
portfolio, we calculate the fraction of dollar volume relative to the total dollar
volume summed over all four portfolios. This percentage is then averaged across
time. Our second measure, ‘Amihud Measure’, is the Amihud (2002) illiquidity
measure. We calculate a monthly measure by taking the ratio of absolute value
of daily return scaled by daily dollar volume, averaged within a month. For each
portfolio we report the average of this measure across the allocated securities in the
pre-formation quarter and then across time. For small stocks there is no evidence
of a monotonic sort on percent dollar volume. However, illiquidity, proxied by
the Amihud measure, increases monotonically from the lowest to the highest limit
portfolios.
‘Campbell IV’ is a monthly estimate of stock idiosyncratic volatility calculated
based on daily data for each firm as in Campbell et al. (2001). High residual
variability firms are more volatile under this measure as well. Dividend yield is
calculated as the difference between the buy and hold return including dividends in
the 12 months post-formation and the buy and hold return, over the same period,
excluding dividends. We then average these yields across firms in a given portfolio
and then across time. Dividend yield falls from low residual variability to high
residual variability. Pontiff (1996) explains that dividend yield may lower arbitrage
costs by shortening the duration of a position in a mispriced security. Hoberg and
Prabhala (2009) also find that idiosyncratic volatility is negatively correlated with
dividend yield.5 Finally, percent of market cap is an estimate of the wealth invested
5
An alternative proxy for limited arbitrage in the context of anomalies involving overvaluation is
the cost of shorting. While we do not have access to such data, the evidence in Geczy et al. (2002) is
168 A. BRAV ET AL.
in each portfolio. It is the proportion of dollars invested in each portfolio in the

pre formation period relative to the full CRSP sample averaged over the entire time
period. Sorting on residual variability generates a spread in wealth invested even
within this small stock universe. The amount of wealth invested in the high residual
variability firms is half that invested in low limits to arbitrage firms.
Our results for small stocks are difficult to interpret, however, since small stocks
include both overperforming small value stocks and underperforming small growth
stocks. Panel B of Table I presents results for only small growth stocks. We define
“growth” as firms in the bottom book to market quintile, using breakpoints for
the full universe of firms on the NYSE, AMEX, and NASDAQ. We immediately
see evidence confirming the limits of arbitrage argument for small growth stocks
since the poor performance of small growth stocks is driven entirely by poor perfor-
mance in the highest residual variability portfolios.6 Indeed while the Sharpe Ratio
of the highest residual variability subset of small growth stocks is −0.23, the lowest
residual variability small growth stocks have a Sharpe Ratio of 0.43. The relative
poor performance of high residual variability small growth stocks compared with
low residual variability small growth stocks is both a return and standard deviation
effect. High residual variability small growth stocks return negative 68 basis points
per month with a standard deviation of more than 10% per month. The four factor
model cannot explain these poor returns. The alpha is −1.52% per month with a
t-statistic of −3.77. The level of institutional holding, stock price level, number of
analysts and dividend yield are high in the low residual variability portfolio, Q1-
Low, and decline monotonically to the high residual variability portfolio Q4-High.
Both illiquidity measures indicate that stocks in Q4-High are more illiquid. Notably,
however, the set of small growth stocks that are anomalous against the CAPM and
the four-factor model are a tiny subset of the CRSP universe market capitalization,
less than 0.10%.
Table II presents the results of zero cost portfolio CAPM regressions that are
long the high residual variability small growth portfolio and short the low residual
variability small growth portfolio. Under the null of the limits of arbitrage argu-
ment, the sign on the small growth regression alpha should be negative, since the
negative alpha for small growth stocks should be strongest in the highest residual
variability portfolio if the anomaly is strongest where limits to arbitrage are high-
est. This is what we find. The CAPM alpha of the zero cost portfolio regression
is −1.73 with a t-statistic of −6.05. The 95% confidence interval is from −2.30
to −1.17. We also calculate the Bayesian posterior odds using the methodology of
that it is possible to borrow shares of firms conducting an IPO, suggesting that these costs may not
bind for firms which historically have earned poor returns perhaps due to overvaluation.
6
This poor performance is consistent with the evidence in Ang et al. (2006) who show that high
levels of idiosyncratic variance, measured using daily returns, predicts low subsequent average returns,
controlling for an array of firm characteristics.
Table II. Zero cost portfolio regressions: 1963–2007

We form zero cost portfolios that are long the highest residual variability portfolios and short the
lowest residual variability portfolios from Tables I, III, IV, and V. The table reports CAPM alphas,
t-statistics, and 95% confidence intervals for the CAPM alpha. Posterior odds are calculated as in
Zellner and Siow (1979) for the hypothesis that the alpha is greater than zero versus less than zero.
The posterior odds are approximately F(t)/F(-t) where t is the t-statistic and F(.) is the cumulative
standard normal distribution.
CAPM Alpha t-statistic 95% C. I. Posterior Odds
Small Growth −1.73 −6.05 −2.30 to −1.17 7.35 E-10

Small Value −0.21 −0.95 −0.63 to 0.22 0.20
Growth −1.01 −3.43 −1.59 to −0.43 3.02 E-04
Value −0.05 −0.22 −0.48 to 0.38 0.71
Winners −0.23 −0.86 −0.74 to 0.29 0.24
Small Winners −0.96 −3.59 −1.48 to −0.44 1.68 E-04
Losers −1.43 −5.13 −1.97 to −0.88 1.46 E-07
Small Losers −1.27 −4.62 −1.81 to −0.73 1.90 E-06
PEAD: Positive Earnings −0.64 −3.20 −1.02 to −0.25 6.88 E-04
Surprises (Small Firms)
PEAD: Negative Earnings −0.58 −2.75 −1.00 to −0.17 2.98 E-03
Surprises (Small Firms)
Zellner and Siow (1979) who approximate the posterior odds for the test that the
mean is greater than zero versus less than zero as (prior odds)×(F(t)/F(-t), where F is
the cumulative standard normal distribution, and the prior probability distributions
are Cauchy centered on zero and diffuse on the standard deviation. With even prior
odds (that is, a prior belief that it is equally likely that the high residual portfolio is
lower than the low residual variability portfolio as it is that the opposite is true) the
posterior odds for the hypothesis that the high residual variability portfolio earns
more than the low residual variability portfolio are vanishingly small at 7.35 E-10.
In other words, the odds on the limits of arbitrage argument for small growth stocks
are about 1.4 billion to 1 in favor of that hypothesis.
Panel C of Table I presents results for small value stocks. These are firms which
are classified in the sorting month as falling in the bottom size quintile and the top
book to market quintile. Inconsistent with limits of arbitrage explanations of high
returns to small value stocks, the highest CAPM and four factor alphas occur in
the lowest residual variability portfolio subset of the small value stocks. Similarly,
the Sharpe Ratio of the lowest residual variability portfolio is much higher than the
Sharpe Ratio of the highest residual variability portfolio (0.84 versus 0.52). This
is largely a standard deviation effect. While the low residual variability portfolio
of small value stocks earns 4 basis points less per month relative to the high limits
portfolio, the standard deviation of the highest residual variability portfolio is 60%
higher (8.06 versus 4.80). The CAPM alpha is larger for low limits small value
stocks than high limits small value stocks. It is worth noting that not even the
170 A. BRAV ET AL.
four-factor model can explain low residual variability small value stocks. The four-
factor alpha is 0.32 with a t-statistic of 3.60. There is no four-factor anomaly in
high residual variability small value stocks.
long the high residual variability small value portfolio and short the low residual
variability small value portfolio. Under the null of the limits of arbitrage argument,
the sign on the small value regression alpha should be positive, since the positive
alpha generated by small value stocks should be strongest in the highest residual
variability portfolio if the anomaly is strongest where limits to arbitrage are highest.
We do not find support for the limits of arbitrage argument for small value stocks.
The CAPM alpha of the zero cost portfolio regression is negative, not positive as
expected under the null, at −0.21 with a t-statistic of −0.95. The 95% confidence
interval is from −0.63 to 0.22. While the 95% confidence interval contains positive
numbers up to 0.22, so that it is possible at that level of significance to fail to
reject the limits of arbitrage argument for differences up to that level, the Bayesian
posterior odds put the odds on the limits of arbitrage argument at only 0.20 for
small value stocks. That is, with even prior odds before the regression, the Bayesian
posterior odds inference is 5:1 ([1/0.20]:1) against the hypothesis that the high
residual variability small value stocks earn higher returns (as expected under the
null of the limits of arbitrage argument) versus the opposite. Put another way, even
someone who came to the data with a strong prior belief 5:1 in favor of the limits
of arbitrage argument for small value stocks (i.e., 83.3% probability that the limits
of arbitrage argument for small value stocks is true, 16.7% probability that it is
not) would be left indifferent after seeing the data, with equal parts belief for and
against the limits of arbitrage argument for small value stocks.7
4.2 VALUE AND GROWTH STOCKS
Panel A of Table III presents results for growth stocks. We define “growth” as firms
in the bottom book to market quintile, using breakpoints for the full universe of
firms on the NYSE, AMEX, and NASDAQ. Firms are further allocated into quartile
sorts based on the magnitude of their estimated residual variability. Q1-Low (Q4-
High) is a portfolio holding firms with lowest (highest) residual variability. As with
small growth stocks, Panel A demonstrates that the poor performance in growth
stocks occurs in the highest residual variability portfolios.
7
It is possible that the correlation that we document between portfolios’ average return and standard
deviation is due to skewness in portfolio returns, where positive (negative) skewness leads to estimates
of mean and variance that are positively (negatively) correlated; We have tested for this possibility by
estimating the average portfolio return on the odd-numbered time-series observations and the standard
deviation on the even-numbered observations. This effectively generates estimates from independent
samples. We find that the results in this section as well as those below remain qualitatively unchanged.
Table III. Post-formation results for the “growth” and “value” stock subsample: 1963–2007
We begin with the universe of firms traded on NYSE, AMEX, and NASDAQ with CRSP common
share codes 10 or 11. In Panel A we focus on firms in the lowest book-to-market quintile whereas
in Panel B we narrow the universe to firms in the highest book to market quintile. The portfolio
formation and resulting characteristics are defined in Table I.
Panel A: Growth Stock Universe

Sharpe Ratio 0.30 0.25 0.12 −0.10 0.31
CAPM Alpha −0.03 −0.13 −0.43 −1.05 −0.07
T-stat Alpha −0.43 −0.97 −2.37 −4.01 −1.14
Four-Factor Alpha 0.18 0.17 −0.23 −0.82 0.13
T-stat Alpha 2.75 1.47 −1.48 −3.83 2.98
Four-Factor SMB Loading −0.23 0.07 0.43 0.92 −0.14
Four-Factor HML Loading −0.30 −0.60 −0.59 −0.59 −0.35
Four-Factor MOM Loading −0.02 0.06 0.14 0.08 0.02
Four-Factor R2 90.41 87.33 82.42 74.48 95.64
Median Price 39.25 26.28 15.58 7.10 20.97
Amihud Measure 0.18 1.00 3.76 10.93 3.75
Campbell IV 7.14 11.07 15.51 21.30 13.62
Dividend Yield 2.43 1.36 0.83 0.41 1.29
Panel B: Value Stock Universe
Sharpe Ratio 0.60 0.47 0.56 0.44 0.60
CAPM Alpha 0.40 0.27 0.55 0.35 0.40
T-stat Alpha 3.24 1.86 2.82 1.62 3.43
T-stat Alpha −0.36 −0.32 −0.21 −0.76 −0.36
Four-Factor MOM Loading −0.07 −0.12 0.00 −0.03 −0.08
Four-Factor R2 81.65 81.09 80.94 74.67 89.66
Median Price 20.41 12.16 7.38 4.40 9.78
Amihud Measure 2.45 6.70 18.25 47.52 18.01
Campbell IV 8.31 12.54 17.04 23.51 15.18
Dividend Yield 4.95 2.55 1.43 0.77 2.51
172 A. BRAV ET AL.
The low returns to growth stocks are a phenomenon of the high residual vari-
ability portfolio. The high residual variability CAPM alpha is −1.05 percent per
month with a t-statistic of −4.01. The four-factor model cannot price high resid-
ual variability small growth stocks. The four-factor alpha of the highest residual
variability portfolio is −0.82 with a t-statistic of −3.83. The CAPM alpha of the
low residual variability portfolio is insignificantly different from zero, while the
four-factor alpha is positive and statistically significant, partly, it appears, because
low residual variability growth stocks earn good returns despite loading negatively
on the HML factor. That is, low residual variability growth firms covary strongly
with other growth stocks but do not suffer their same poor returns. High residual
variability growth stocks covary even more strongly (negatively) with HML but
perform much worse than expected under the four factor model given their large
market betas and SMB loadings.
The Sharpe Ratio of the highest residual variability subset of growth stocks is
−0.10 while the lowest residual variability growth stocks have a Sharpe Ratio of
0.30. The low Sharpe Ratio found in high residual variability growth stocks is both
a return and standard deviation effect. High residual variability growth stocks return
minus 28 basis points per month, on average, with a standard deviation of about
10% per month. The anomalously poor performing growth stocks comprise less
than 3% of the CRSP universe market capitalization.
Table II presents the results of zero cost portfolio CAPM regressions that are long
the high residual variability growth portfolio and short the low residual variability
growth portfolio. Under the null of the limits of arbitrage argument, the sign on
the growth regression alpha should be negative, since the negative alpha for growth
stocks should be strongest in the highest residual variability portfolio if the anomaly
is strongest where limits to arbitrage are highest. This is what we find. The CAPM
alpha of the zero cost portfolio regression is −1.01 with a t-statistic of −3.43. The
95% confidence interval is from −1.59 to −0.43. The posterior odds for the limits
of arbitrage argument are about 3,000 to 1 ([1/3.02 E-04]:1).
Panel B of Table III presents results for value stocks. These are firms which are
classified in the sorting month as falling in the top book to market quintile. The high
residual variability CAPM alpha is insignificant. There is no value stock anomaly
in high residual variability value stocks. The low residual variability CAPM alpha
is 40 basis points per month with a t-statistic of 3.24. The Sharpe ratio of the lowest
residual variability portfolio, 0.60, is nearly 40% higher than the Sharpe ratio of
the highest residual variability portfolio, 0.44. This is a standard deviation effect.
The high residual variability portfolio earns 24 basis points a month more than the
lowest residual variability portfolio but its standard deviation is almost twice as
high.
Table II presents the results of zero cost portfolio CAPM regressions that are long
the high residual variability value portfolio and short the low residual variability
value portfolio. Under the null of the limits of arbitrage argument, the sign on the
value regression alpha should be positive, since the positive alpha generated by value
stocks should be strongest in the highest residual variability portfolio if the anomaly
is strongest where limits to arbitrage are highest. As for small value stocks, we do
not find support for the limits of arbitrage argument for value stocks. The CAPM
alpha of the zero cost portfolio regression is negative, not positive as expected under
the null, at −0.05 with a t-statistic of −0.22. The 95% confidence interval is from
−0.48 to 0.38. While the 95% confidence interval contains positive numbers up
to 0.38, so that it is possible at that level of significance to fail to reject the limits
of arbitrage argument for differences up to that level, the Bayesian posterior odds
put the odds on the limits of arbitrage argument at 0.70 for value stocks. That is,
with even prior odds before the regression, the Bayesian posterior odds inference
is 1.41:1 against the hypothesis that the high residual variability value stocks earn
higher returns (as expected under the null of the limits of arbitrage argument)
versus the opposite. Put another way, even someone who came to the data with
a prior belief 1.41:1 in favor of the limits of arbitrage argument for value stocks
(i.e., 70.5% probability that the limits of arbitrage argument for value stocks is true,
29.5% probability that it is not) would be left indifferent after seeing the data, with
equal parts belief for and against the limits of arbitrage argument for value stocks.
4.3 RECENT WINNER AND LOSER STOCKS
Panel A of Table IV presents results for recent winners. We define recent win-
ners as firms whose 11-month buy and hold return leading up to the month
prior to the formation period places them in the top quintile of price momentum.
Panel A of Table IV demonstrates that the abnormal return in recent winners is weak-
est in the highest residual variability environment. There is no CAPM anomaly for
recent winners in high residual variability portfolios: the high residual variability
alpha is an insignificant 0.14 basis points per month. The low residual variability
CAPM alpha, however, is 36 basis points per month with a t-statistic of 3.44. The
Sharpe Ratio of the highest residual variability subset of recent winners is 0.34
while the lowest residual variability recent winners have a Sharpe Ratio of 0.59.
This is a standard deviation effect. High residual variability recent winners return
6 basis points more than the lowest residual variability portfolio while the standard
deviation of the highest residual variability portfolio is 8.94 compared with 4.80
for the low residual variability portfolio. In Panel B, we restrict the sample to small
winners, firms that belong to the bottom size quintile on CRSP. None of conclusions
drawn are sensitive to conditioning on firm size.
long the high residual variability winner (and small winner) portfolio and short the
low residual variability winner (and small winner) portfolio. Under the null of the
174 A. BRAV ET AL.
Table IV. Post-formation results for the “winner” and “loser” stock subsample: 1963–2007
We begin with the universe of all firms traded on NYSE, AMEX, and NASDAQ with CRSP common
share codes 10 or 11. “Winners” (“Losers”) are determined by assigning firms to the highest (lowest)
price momentum quintile. Price momentum is measured using past one-year return skipping the
pre-formation month. In Panels B and D we further restrict the momentum samples to “Small” firms,
those whose market capitalization is in the bottom size quintile. The quartile portfolio formation and
resulting characteristics are defined in Table I.
Panel A: Winner Stock Universe

Sharpe Ratio 0.59 0.60 0.58 0.34 0.59
CAPM Alpha 0.36 0.54 0.59 0.14 0.38
T-stat Alpha 3.44 3.57 3.19 0.55 3.68
Four-Factor Alpha −0.08 0.01 0.13 −0.32 −0.06
T-stat Alpha −1.20 0.11 0.88 −1.70 −1.02
Four-Factor HML Loading 0.06 −0.05 −0.19 −0.16 −0.01
Four-Factor R2 89.91 85.40 82.77 72.73 94.31
Median Price 34.03 24.69 16.49 8.97 20.39
Amihud Measure 0.63 1.19 2.36 10.16 3.47
Campbell IV 8.15 10.83 14.08 19.84 13.18
Dividend Yield 3.39 2.14 1.34 0.66 1.90
Panel B: Small Winner Stock Universe
Sharpe Ratio 1.04 0.91 0.68 0.35 0.60
CAPM Alpha 0.91 1.04 0.70 −0.04 0.72
T-stat Alpha 5.48 4.74 2.68 −0.14 3.75
T-stat Alpha 2.85 1.81 −0.27 −2.35 0.23
Four-Factor R2 82.32 81.54 76.23 69.68 83.59
Median Price 18.62 13.13 9.55 6.39 11.57
Amihud Measure 2.39 3.23 4.67 15.73 6.39
Table IV. Continued

Campbell IV 11.13 14.22 17.19 22.38 16.19
Dividend Yield 3.15 1.66 0.93 0.51 1.57
Panel C: Loser Stock Universe
Average Excess Return 0.32 0.20 −0.11 −0.88 0.24
Sharpe Ratio 0.18 0.09 −0.05 −0.32 0.13
CAPM Alpha −0.19 −0.44 −0.81 −1.61 −0.33
T-stat Alpha −1.17 −2.37 −3.46 −5.80 −2.25
T-stat Alpha 4.41 1.12 −2.05 −5.21 3.48
Four-Factor HML Loading 0.09 −0.03 0.04 −0.06 0.04
Four-Factor MOM Loading −0.77 −0.70 −0.59 −0.54 −0.74
Four-Factor R2 89.54 87.83 80.14 74.70 93.03
Median Price 17.29 10.17 6.15 3.45 8.08
Amihud Measure 4.14 11.32 21.68 45.11 20.09
Campbell IV 10.70 15.70 20.26 25.74 18.05
Dividend Yield 3.26 1.66 0.89 0.41 1.61
Panel D: Small Loser Stock Universe
Sharpe Ratio 0.31 0.12 0.08 −0.14 0.12
CAPM Alpha 0.05 −0.38 −0.51 −1.22 −0.35
T-stat Alpha 0.25 −1.56 −1.81 −3.61 −1.67
T-stat Alpha −0.30 −2.03 −1.99 −2.84 −2.22
Four-Factor MOM Loading −0.43 −0.48 −0.42 −0.47 −0.44
Four-Factor R2 87.01 84.74 73.08 66.89 83.68
Median Price 9.03 5.60 3.88 2.74 4.84
Amihud Measure 10.20 19.25 30.64 52.97 27.85
Campbell IV 14.07 19.06 22.83 27.20 20.74
Dividend Yield 2.33 1.03 0.60 0.33 1.11
176 A. BRAV ET AL.
limits of arbitrage argument, the sign on the winner and small winner regression
alphas should be positive, since the positive alpha generated by winner and small
winner stocks should be strongest in the highest residual variability portfolio if the
anomaly is strongest where limits to arbitrage are highest. As with small value and
value stocks, we do not find support for the limits of arbitrage argument for winner
or small winner stocks. The CAPM alphas of both zero cost portfolio regression
are negative, not positive as expected under the null, at −0.23 with a t-statistic of
−0.86 for winners, and −0.96 with a t-statistic of −3.59 for small winners. The
95% confidence interval for winners is from −0.74 to 0.29 and for small winners
is −1.48 to −0.44. While the 95% confidence interval for winners (but not small
winners) contains positive numbers up to 0.29, so that it is possible at that level
of significance to fail to reject the limits of arbitrage argument for differences up
to that level, the Bayesian posterior odds put the odds on the limits of arbitrage
argument for winners at 0.24. That is, with even prior odds before the regression,
the Bayesian posterior odds inference is 4.17:1 against the hypothesis that the high
residual variability value stocks earn higher returns (as expected under the null
of the limits of arbitrage argument) versus the opposite. The posterior odds for
small winners are 1.68 E-04, or more than 6,000 to 1 against the limits of arbitrage
argument.
Panel C of Table IV presents results for recent losers. Consistent with our results
on other negative anomalies, the worst alphas and Sharpe Ratio are in the highest
residual variability portfolio. When we further restrict the sample to small loser
firms in Panel D we find again that the conclusions are not sensitive to conditioning
on firm size. Table II reports that the posterior odds are overwhelmingly in favor
of the limits of arbitrage hypothesis. In unreported results we find that high limits
losers are disproportionately small growth firms, consistent with the evidence in
Table I, Panel B.8
4.4 RESULTS FOR THE POST-EARNINGS ANNOUNCEMENT DRIFT ANOMALY
In this section we extend our analysis and ask whether similar evidence exists
in event-study-based anomalous price reactions. In particular, we focus on the
well-known post-earnings announcement drift (Ball and Brown, 1968; Bernard and
Thomas, 1990), the evidence that stock prices tend to drift in the same direction as
the earnings news for three quarters post-event. We begin with the universe of all
firms traded on NYSE, AMEX, and NASDAQ with CRSP common share codes 10
8
In unreported analysis, we check whether results in this section are sensitive to industry concentra-
tion, namely, whether low or high idiosyncratic risk stocks tend to concentrate in specific industries.
We find that low limits to arbitrage stocks tend to have higher representation from industries such as
banking, utilities, and financials. However, when we remove these industries from the analysis in this
section and repeat our tests we find that our conclusions remain unchanged.
or 11. We then construct decile portfolios sorted based on standardized unexpected

earnings (“SUE”). SUE is measured, each quarter, as the difference between a firm’s
reported earnings and expected earnings where the latter expectations are calculated
assuming earnings follow a seasonal random walk with a drift. Beginning in July
1972 we sort firms into deciles based on their most recent quarterly SUE and hold
these firms for three months. Following Chordia et al. (2006) we exclude firms
whose stock price is below five dollars in the pre-formation month. We check that
our sample firms exhibit the same magnitude of abnormal return as documented
elsewhere in the literature (e.g., Chordia et al., 2006) by calculating equal weight
calendar-time portfolio returns for the SUE deciles. A portfolio that is long in the
most positive earnings surprise firms and short the most negative surprise firms
earns a four factor alpha of 96 basis points, which is similar to that reported in
Chordia et al. (2006).9
Since our tests are based on calendar-time portfolios in which firm returns are
value weighted rather than equal weighted, we present, in Table V, four-factor re-
gression alphas estimated for decile portfolios in which firms are allocated based on
their most recently calculated SUE. Firm returns are value weighted and we rebal-
ance quarterly through December 2007. We denote ‘D1’ through ‘D10’ portfolios
holding securities with the lowest through highest SUEs and report four-factor
regression alphas and associated t-statistics for the full sample in Panel A. Once re-
turns are value weighted, the post-earnings announcement drift is less “anomalous,”
as only the high SUE decile, D10, indicates evidence of economically meaningful
mispricing relative to the four-factor model (19 basis points with a t-statistic =
2.24).
Since full sample evidence indicates that most of the drift is driven by small
firms, and our goal is to examine the link between potential mispricing and residual
variability, we proceed to narrow our sample of firms to those in the lowest size
quintile (see Section 4.1) and form SUE quintile portfolios. The regression alphas
are now presented in Panel B of Table V. The lowest SUE portfolio underperforms
by 77 basis points per month (t-statistic = −6.79) and alphas increase nearly
monotonically to the high SUE decile whose four-factor alpha is 33 basis points
(t-statistic = 2.40).
With this pattern of drift in the extreme portfolios, we proceed, in Panel C, and ask
whether the abnormal drift is concentrated in firms with high residual variability.
We sort firms independently on both SUE and residual variability. Beginning in
July 1972, we determine quintile breakpoints based on lagged firms’ SUE and
median breakpoints based on residual variability measured in the pre-formation
five-year period as described in Table I. We allocate firms into the resulting ten
9
Chordia et al. (2006)’s sample contains all NYSE and AMEX stocks with prices greater than five
dollars and extends over a similar time period as ours, 1972–2004, and they report a four-factor alpha
of 65 basis points.
178 A. BRAV ET AL.
Table V. Post earnings announcement drift: 1972–2007

The universe is all firms traded on NYSE, AMEX, and NASDAQ with CRSP common share codes
10 or 11. The table provides regression results for decile portfolios sorted based on standardized
unexpected earnings (“SUE”). SUE is measured, each quarter, as the difference between a firm’s re-
ported earnings and expected earnings where the latter expectations are calculated assuming earnings
follow a seasonal random walk with a drift. Beginning in July 1972 we sort firms into deciles based
on their most recent quarterly SUE and hold firms for three months. The notation ‘D1’ through ‘D10’
refers to a portfolio holding the securities with the lowest through the highest SUEs. Firm returns are
value weighted and we rebalance quarterly through December 2007. We exclude firms with prices
below five dollars in the pre-formation month. In Panel A we report four factor regression alphas
and associated t-statistics for the full sample. The four factors are the Fama and French RMRF, SMB,
HML factors including a momentum factor, MOM. The four factors and the size quintile breakpoints
are obtained from Ken French’s web site. Panel B provides regression results for “small” firms.
“Small” firms are identified as firms whose market capitalization is in the bottom size quintile. Firm
size is the market capitalization in the month of July preceding portfolio formation. Beginning in
July 1972 we sort firms into quintiles based on their most recent quarterly SUE and hold firms for
three months. The notation ‘Q1’ through ‘Q5’ refers to a portfolio holding the securities with the
lowest through the highest SUEs. Panel C provides regression results for the small firm sample where
portfolios are sorted independently on both firm SUE and idiosyncratic volatility. Beginning in July
1972 we determine quintile breakpoints based on lagged firm SUE and median breakpoints based
on idiosyncratic volatility measured in the pre-formation five-year period as described in Table I. We
allocate firms into the resulting ten portfolios and calculate value weight results for the ensuing three
months. We rebalance these portfolios quarterly.
Panel A: CRSP Universe
D1 D2 D3 D4 D5 D6 D7 D8 D9 D10
Alpha 0.08 −0.04 −0.16 −0.14 −0.09 0.00 0.11 0.09 0.08 0.19
T-statistic 0.90 −0.46 −1.90 −1.83 −1.15 −0.02 1.37 1.16 1.05 2.24
Panel B: Small Firm Sample
Q1 Q2 Q3 Q4 Q5
Alpha −0.77 −0.41 −0.15 0.13 0.33

T-statistic −6.79 −3.30 −1.26 1.06 2.40
Panel C: Small Firm Sample: Double Sort
Q1 Q2 Q3 Q4 Q5
Low IV Alpha −0.35 −0.11 0.11 0.24 0.62

T-statistic −3.25 −1.08 0.99 2.11 5.42
High IV Alpha −0.87 −0.61 −0.31 −0.04 −0.02
T-statistic −4.72 −2.77 −1.67 −0.24 −0.12
portfolios and calculate value weight results for the ensuing three months. We
rebalance these portfolios quarterly. The regression alphas are presented in Panel C
of Table V. The first two rows (“Low IV Alpha”) provide quintile SUE portfolio
alphas and t-statistics for low residual variability stocks. The next two rows (“High
IV Alpha”) provide alphas and t-statistics for quintile SUE portfolios formed using
high residual variability stocks.
Negative drift for extreme negative SUE portfolio is significant in both the high
volatility portfolio with a negative 87 basis point alpha (t-statistic = −4.72) and
the low volatility portfolio yields a marginally significant alpha of negative 35
basis points (t-statistic = −3.25). This evidence is consistent with the predictions
regarding overvaluation that we have discussed earlier. However, we can also see
that the positive drift subsequent to positive earnings news is confined entirely to
low residual variability portfolios, whereas the high residual variability portfolio
alphas are all insignificantly different from zero. The alpha in the extreme positive
SUE portfolio is large and significant only in the low volatility portfolio with a 62
basis point alpha (t-statistic = 5.42). The corresponding high volatility portfolio
yields an insignificant alpha of negative 2 basis points (t-statistic = −0.12).
long the high residual variability portfolio of positive earnings surprises for small
firms and short the low residual portfolio of positive earnings surprises for small
firms. Under the null of the limits of arbitrage argument, the sign on the regression
alpha should be positive, since the positive alpha generated by the portfolio of
positive earnings surprises for small firms should be strongest in the highest residual
variability portfolio if the anomaly is strongest where limits to arbitrage are highest.
We do not find support for the limits of arbitrage argument for the portfolios of
positive earnings surprises for small firms. The CAPM alpha of the zero cost
portfolio regression is negative, not positive as expected under the null, at −0.64
with a t-statistic of −3.20. The 95% confidence interval is from −1.02 to −0.25.
The Bayesian posterior odds put the odds on the limits of arbitrage argument at only
0.20 for small value stocks. That is, with even prior odds before the regression, the
Bayesian posterior odds inference is 355:1 ([1/2.98 E-03]:1) against the hypothesis
that the high residual variability portfolio earns higher returns (as expected under
the null of the limits of arbitrage argument) versus the opposite. As with our earlier
results, the evidence is consistent with the limits of arbitrage for the negative
earnings surprises for small firms, with a CAPM alpha of −0.58, a t-statistic of
−2.75, a 95% confidence interval of −1.00 to −0.17, and Bayesian posterior odds
of about 1453:1 in favor of the limits of arbitrage argument.10
10
The evidence from recent work on the “accrual anomaly” (see Sloan, 1996) by Lev and Nissim
(2006) indicates that our conclusions extend beyond the “anomalies” studied in this paper. Lev and
Nissim (2006) show that the inverse relation between accounting accruals and subsequent returns is
180 A. BRAV ET AL.
5. Profitability of Value Strategies Conditioned on Past Stock Price

Momentum
The tests presented in Section 4 were based on predictions from the behavioral
literature linking residual variability (and other correlated firm characteristics) to
the magnitude of observed anomalies. Consider again the description from Barberis
and Thaler (2003):
Noise trader risk . . . is the risk that the mispricing being exploited by the arbitrageur worsens
in the short run. . . . [T]he arbitrageur [] faces the risk that the pessimistic investors causing
Ford to be undervalued in the first place become even more pessimistic, lower its price even
further. Once one has granted the possibility that a security’s price can be different from its
fundamental value, then one must also grant the possibility that future price movements will
increase the divergence.
Under this hypothesis, the superiority of value stocks should be highest for
stocks exhibiting “loser” momentum trends since arbitrageurs, who are aware of
these momentum characteristics, are presumably reluctant to purchase value stocks
that are more likely to continue to underperform in the short run. Similarly, the
underperformance of growth stocks should be stronger for firms exhibiting recent
high price appreciation, namely, momentum “winners,” because arbitrageurs will
not want to bet against growth stocks that are more likely to continue to appreciate
in price.
Table VI presents results for these tests. We form four portfolios by sorting
firms based on their pre-formation book-to-market and momentum characteristics.
The sample is the universe of all firms traded on NYSE, AMEX, and NASDAQ
with CRSP common share codes 10 or 11, further constrained to firms in the
bottom quintile by firm size.11 We form four portfolios requiring that each be al-
located a minimum of 50 firms in the formation period. The portfolios are value
weighted and rebalanced quarterly. The first portfolio, ‘Loser-Value,’ holds firms
in the bottom momentum quintile and highest book-to-market quintile. The second
portfolio, ‘Loser-Growth,’ holds stocks in the bottom quintiles by both momen-
tum and book-to-market. The third portfolio, ‘Winner-Value,’ holds stocks in the
highest momentum and book-to-market quintiles. The fourth portfolio, ‘Winner-
Growth,’ holds stocks in the highest momentum quintile and bottom book-to-market
confined to firms with high accruals that, ex-post, tend to underperform standard size and book to
market benchmarks (see their Table I and the discussion in Section 6). There is no reliable evidence
of undervaluation. Lev and Nissim (2006) also show that high accrual firms are characterized by
high residual variability, low market capitalizations, low book to market ratios, low prices, and
reduced likelihood of institutional ownership. These firms have precisely the same characteristics of
overvalued firms that we find in high limits to arbitrage environments.
11
We focus on the bottom size quintile since both value and momentum premia are larger for this
subset of stocks. We have conducted the same analysis for the full universe and the results remain
qualitatively unchanged.
Table VI. Tests of noise trader risk as a limit to arbitrage: 1963–2007

Firms are sorted into portfolios based on their pre-formation book-to-market and momentum charac-
teristics. We begin with the universe of all firms traded on NYSE, AMEX, and NASDAQ with CRSP
common share codes 10 or 11. The sample is further constrained to firms in the bottom quintile by
firm size. We form four portfolios requiring that each be allocated a minimum of 50 firms in the
formation period. The portfolios are value weighted and rebalanced quarterly. The first portfolio,
‘Loser-Value,’ holds firms in the bottom momentum quintile and highest book-to-market quintile.
The second portfolio, ‘Winner-Value,’ holds stocks in the highest momentum and book-to-market
quintiles. The third portfolio, ‘Loser-Growth,’ holds stocks in the bottom quintiles by both momentum
and book-to-market. The fourth portfolio, ‘Winner-Growth,’ holds stocks in the highest momentum
quintile and bottom book-to-market quintile. We report the resulting portfolio return characteristics
including CAPM alpha, four-factor factor loadings and alpha, regression R2, and number of monthly
observations. The definition of size, momentum and book-to-market are given in Tables I and IV.
Intersection of Momentum and Book to Market Strategies for Small Stocks
Loser-Value Winner-Value Loser-Growth Winner-Growth
Average Excess Return 0.66 1.71 −0.28 0.87

Standard Deviation 7.93 6.20 8.58 8.68
Sharpe Ratio 0.29 0.95 −0.11 0.35
CAPM Alpha 0.06 1.12 −1.24 0.07
T-stat Alpha 0.24 5.53 −4.19 0.24
Four-Factor Alpha −0.08 0.35 −1.04 −0.41
T-stat Alpha −0.42 2.52 −3.85 −1.40
Four-Factor Market Beta 1.15 1.11 1.23 1.30
Four-Factor SMB Loading 1.20 0.83 1.04 0.87
Four-Factor HML Loading 0.86 0.68 0.02 0.02
Four-Factor MOM Loading −0.46 0.33 −0.31 0.64
Four-Factor R2 78.43 80.51 65.60 74.58
Monthly Observations 459 433 395 359
quintile. As in earlier results, we report portfolio return characteristics including

CAPM alpha, four-factor factor loadings and alpha, regression R2 , and number of
monthly observations.
The evidence in Table VI provides a rejection of both of these predictions.
Consider the value portfolios first. Under the limits of arbitrage argument, the
‘Loser-Value’ portfolio should have a higher CAPM alpha than the ‘Winner-Value’
portfolio because it is more difficult to bet against mispricing in value firms that
are continuing to do poorly. But the CAPM alpha of the ‘Loser-Value’ portfolio is
an insignificant 0.06 (t-statistic 0.24 while the CAPM alpha of the “Winner-Value’
portfolio is 1.12 with a t-statistic of 5.53. The Sharpe Ratio of the ‘Winner-Value’
portfolio is 0.95 compared with 0.29 for the ‘Loser-Value’ portfolio.
The results for the growth portfolios also are inconsistent with the noise trader
momentum version of the limits of arbitrage argument. The ‘Loser-Growth’ port-
folio underperforms with a significant CAPM alpha of −1.24 (t-statistic −4.19)
182 A. BRAV ET AL.
while the ‘Winner-Growth’ portfolio has a CAPM alpha of 0.07 (t-statistic 0.24),
the opposite of the outcome expected under the noise trader momentum risk null
hypothesis.
6. Four Factor Premiums in Low Limits to Arbitrage Environments
In our final set of tests, we ask whether there is a factor premium for size, book-to-
market, and momentum in portfolios comprised of the lowest residual variability
stocks. The lowest residual variability stocks not only have low idiosyncratic risk
but also have high median prices, high institutional holdings, a larger number of
analysts, considerable liquidity, high dividend yields, and comprise a large part of
the market capitalization of the entire market. It is difficult to argue that limits of
arbitrage are meaningful in these stocks. If the factor premiums for size, book-to-
market, and momentum were driven entirely by irrationality then we would expect
very little covariation with these factors in the lowest residual variability portfolios.
Our previous results already shed some light on this hypothesis: even our lowest
limits to arbitrage portfolios load strongly on the SMB and HML factors. To test
this more directly, Table VII reports the results of zero cost portfolio regressions
where the relevant zero cost portfolio is long one low limits portfolio and short
another low limits portfolio. Panel A reports the results of regressions of the returns
to the zero cost portfolio that is long low limits small stocks and short low limits
large stocks. Each low limit portfolio consists of firms whose residual standard
deviation is in the bottom quartile of the respective distribution of pre formation
residual standard deviations. The first regression in Panel A is of the returns to that
zero cost portfolio on the other known sources of covariation in stocks returns, i.e.,
the three other factors, excluding SMB. The low limits small-minus-big portfolio
loads 0.28 on HML with a t-statistic of 3.36 but does not load significantly on
RMRF or MOM. There remains an unexplained alpha of 34 basis points per month
with a t-statistic of 1.96. This suggests that there is a size premium even in the
lowest limits to arbitrage portfolios. The next regression of Panel A adds SMB to
the zero cost regression. The loading on SMB is 0.94 with a t-statistic of 9.75.
The alpha then declines to an insignificant 10 basis points. Table VIII, panel A,
presents the same results for the high limits portfolios. While high limits firms do
load more strongly on SMB, there remains a large unexplained negative alpha of
−0.71 (t-statistic −3.71), apparently because the high limits small perform much
worse than would be predicted by their large loading on SMB.
Panel B of Table VII reports the results of regressions on the zero cost portfolio
that is long low limits value stocks and short low limits growth stocks. The first
regression in Panel B is on the three other factors excluding HML. The low lim-
its high-minus-low portfolio loads negatively on RMRF, positively on SMB, and
Table VII. Low limits, zero cost portfolio regressions: 1963–2007

Panel A provides regression results for a zero cost portfolio that is long in low limits “small”
stocks and short low limits “large” stocks. Small (large) stocks are defined as firms whose
market capitalization is in the bottom (top) size quintile in the month of July preceding the
portfolio formation. In the first regression we regress the portfolio returns on RMRF, HML,
and MOM whereas in the second regression we add SMB to the set of factors. Panel B
provides regression results for a zero cost portfolio long in “value” stocks and short “growth”
stocks. Value (growth) stocks are defined as firms whose book-to-market ratio is in the top (bottom)
book-to-market quintile. In the first regression we regress the portfolio on RMRF, SMB, and MOM
whereas in the second regression we add HML to the three factors. Panel C provides regression results
for the sample in panel B restricted to “small” firms. Panel D provides regression results for a zero
cost portfolio long in recent “winners” and short recent “losers.” Winners and losers are defined as
firms whose recent one-year buy and hold return is in the top (bottom) momentum quintile. In the
first regression we estimate slopes on RMRF, SMB, and HML, whereas in the second regression we
add MOM to the three factors. Panel E provides regression results for the sample in panel D restricted
to “small” firms. Each low limit portfolio consists of firms whose residual standard deviation is in
the bottom quartile of the respective distribution of pre formation residual standard deviations.
Alpha RMRF SMB HML MOM R2 OBS
Panel A: Small minus Large

Estimates 0.34 0.08 0.28 −0.06 5.00 533
T-statistics 1.96 1.41 3.36 −0.98
Estimates 0.10 −0.06 0.94 0.48 0.00 68.19 533
T-statistics 1.05 −1.18 9.75 6.20 0.07
Panel B: Value minus Growth
Estimates 0.51 −0.24 0.20 −0.12 9.41 534
T-statistics 3.07 −4.70 2.97 −1.84
Estimates −0.22 0.02 0.38 1.10 −0.05 68.20 534
T-statistics −2.25 0.76 7.23 24.11 −1.54
Panel C: Small Value minus Small Growth
Estimates 0.92 −0.41 −0.26 −0.15 25.95 458
T-statistics 5.33 −6.09 −1.49 −1.66
Estimates 0.44 −0.23 −0.14 0.68 −0.11 42.81 458
T-statistics 2.74 −2.41 −0.79 4.81 −1.23
Panel D: Winners minus Losers
Estimates 0.66 −0.17 −0.19 −0.20 3.19 534
T-statistics 2.55 −1.88 −1.54 −1.25
Estimates −0.52 −0.09 −0.04 −0.02 1.24 80.00 534
T-statistics −4.71 −2.25 −0.69 −0.38 30.22
Panel E: Small Winners minus Small Losers
Estimates 1.00 −0.03 −0.18 −0.17 2.52 427
T-statistics 4.84 −0.39 −1.35 −1.52
Estimates 0.39 −0.05 −0.19 −0.09 0.73 56.18 427
T-statistics 2.66 −1.09 −2.97 −1.29 17.17
184 A. BRAV ET AL.
Table VIII. High limits, zero cost portfolio regressions: 1963–2007

This table performs the same tests as in Table VII, using high limits portfolios. Each high limit
portfolio consists of firms whose residual standard deviation is in the top quartile of the respective
distribution of pre formation residual standard deviations.
Alpha RMRF SMB HML MOM R2 OBS
Panel A: Small minus Large

Estimates −0.38 0.27 0.24 0.00 3.38 524
T-statistics −1.32 3.13 1.32 0.00
Estimates −0.71 0.07 1.35 0.54 0.10 48.87 524
T-statistics −3.71 0.66 6.40 3.23 0.77
Panel B: Value minus Growth
Estimates 1.56 −0.29 −0.20 −0.19 7.31 531
T-statistics 5.69 −3.37 −1.66 −1.45
Estimates 0.65 0.03 0.02 1.38 −0.10 40.21 531
T-statistics 2.95 0.47 0.27 12.42 −1.25
Panel C: Small Value minus Small Growth
Estimates 2.22 −0.36 −0.14 −0.09 7.93 459
T-statistics 6.57 −3.71 −0.85 −0.52
Estimates 1.49 −0.09 0.04 1.04 −0.03 26.62 459
T-statistics 4.70 −0.95 0.24 5.80 −0.21
Panel D: Winners minus Losers
Estimates 1.91 −0.04 −0.40 −0.26 3.81 533
T-statistics 6.50 −0.40 −2.15 −1.28
Estimates 0.84 0.03 −0.26 −0.10 1.12 47.04 533
T-statistics 3.76 0.45 −2.69 −0.79 12.30
Panel E: Small Winners minus Small Losers
Estimates 1.45 0.04 −0.07 −0.20 1.12 426
T-statistics 5.03 0.35 −0.32 −1.16
Estimates 0.66 0.02 −0.10 −0.07 0.86 30.36 426
T-statistics 2.70 0.34 −0.77 −0.60 7.47
negatively on MOM. There remains an unexplained alpha of 51 basis points with a

t-statistic of 3.07. This suggests that there is a value-growth premium even in the
lowest limits to arbitrage portfolios. The next regression of Panel B adds HML to
the zero cost regression. The loading on HML is 1.10 with a t-statistic of 24.11
while the regression intercept is now negative at −0.22 with a t-statistic of −2.25,
apparently because the difference in returns to the two portfolios is too small rela-
tive to the average return on HML. Table VIII, panel B, presents the same results
for the high limits portfolios. While high limits firms do load more strongly on
HML, there remains a large unexplained alpha of 0.65 (t-statistic 2.95), apparently
because the high limits growth firms perform much worse than would be predicted
by the zero cost portfolio’s loading on HML. Table VII, panel C, presents the re-
sults for only small value minus small growth. There the loading on HML is smaller
and there remains a significant alpha of 0.44 with a t-statistic of 2.74. Table VIII,
panel C, presents the same results for the high limits portfolios. While high limits
small firms do load more strongly on HML, there remains a large unexplained
alpha of 1.49 (t-statistic 4.70), again, apparently because the high limits growth
firms perform much worse than would be predicted by the zero cost portfolio’s
loading on HML.
Panel D of Table VII reports the results of regressions on the zero cost portfolio
that is long low limits recent winners and short low limits recent losers. The first
regression in Panel D is on the three other factors excluding MOM. The low limits
winners-minus-losers portfolio loads slightly negatively on RMRF, SMB, and HML.
There remains an unexplained alpha of 66 basis points a month with a t-statistic
of 2.55. This suggests that there is a momentum premium even in the lowest limits
to arbitrage portfolios. The next regression of Panel D adds MOM to the zero cost
regression. The loading on MOM is 1.24 with a t-statistic of 30.22. The alpha
is now negative at 0.52 with a t-statistic of −4.71, apparently because the zero
cost portfolio, while moving strongly with MOM, does not have a sufficiently low
return since low limits to arbitrage losers do not underperform. Table VIII, panel
D, presents the same results for the high limits portfolios. High limits firms do not
load more strongly on MOM, and there remains a large unexplained positive alpha
of 0.84 (t-statistic 3.76), apparently because the high limits losers firms perform
much worse than would be predicted by the zero cost portfolio’s loading on MOM.
Table VII, panel E, presents the results for only low limits small winner minus
small losers. The alpha now becomes positive, apparently because low limits small
winners perform much better than would be predicted by the zero cost portfolio’s
loading on MOM. Table VIII, panel E, presents the same results for the high limits
portfolios. The results are qualitatively the same, though the alpha is even larger,
apparently because high limits losers perform much worse than would be predicted
by the zero cost portfolio’s loading on MOM.
7. Conclusions
Behavioral explanations of financial anomalies encounter the objection that

irrationality-induced anomalies would be exploited and eliminated by rational arbi-
trageurs. The limits of arbitrage argument counters this objection by asserting that
arbitrage is difficult because idiosyncratic risk and noise trader momentum risk
make arbitrage difficult. This argument is testable because it implies that financial
anomalies should be strongest where limits to arbitrage (i.e., idiosyncratic risk and
noise trader momentum risk) are greatest. We provide those tests in this paper. We
find that the limits of arbitrage argument cannot explain the existence of the un-
dervaluation anomalies (high returns to value stocks, recent winners, and positive
earnings surprises) but can explain the existence of the overvaluation anomalies
186 A. BRAV ET AL.
(low returns to growth stocks, recent losers, and negative earnings surprises). We
find no support, however, for the noise trader momentum risk version of the limits
of arbitrage argument. Taken together, these results are a success for behavioral
explanations of overvaluation anomalies but present a serious challenge to develop
new behavioral explanations for the existence of undervaluation anomalies.
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The Limits of The Limits of Arbitrage: Abstract

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Review of Finance (2010) 14: 157–187

The Limits of the Limits of Arbitrage

JEL Classification: G11, G12, G14

Barberis and Thaler (2003) explain idiosyncratic risk as a deterrent to arbi-

2. Comparison to Studies Finding Support for Limits of Arbitrage

consider separately undervaluation and overvaluation anomalies, and by using re-

3. Data and Implementation

4. Results for Characteristic-Based Anomalies

4.1 SMALL STOCKS

Table I. Post-formation results for the “small” stock subsample: 1963–2007

Q1-Low Q2 Q3 Q4-High All

Panel A: Small Stock Universe

Q1-Low Q2 Q3 Q4-High All

Four-Factor SMB Loading 0.69 1.01 1.16 1.31 1.00

Q1-Low Q2 Q3 Q4-High All

Monthly Observations 458 454 453 459 534

in each portfolio. It is the proportion of dollars invested in each portfolio in the

Table II. Zero cost portfolio regressions: 1963–2007

CAPM Alpha t-statistic 95% C. I. Posterior Odds

Small Growth −1.73 −6.05 −2.30 to −1.17 7.35 E-10

4.2 VALUE AND GROWTH STOCKS

Q1-Low Q2 Q3 Q4-High All

Panel A: Growth Stock Universe

4.3 RECENT WINNER AND LOSER STOCKS

Q1-Low Q2 Q3 Q4-High All

Panel A: Winner Stock Universe

Table IV. Continued

Q1-Low Q2 Q3 Q4-High All

Percent Dollar Volume 17.28 26.07 28.29 28.37 100.00

4.4 RESULTS FOR THE POST-EARNINGS ANNOUNCEMENT DRIFT ANOMALY

or 11. We then construct decile portfolios sorted based on standardized unexpected

Table V. Post earnings announcement drift: 1972–2007

Panel A: CRSP Universe

Panel B: Small Firm Sample

Alpha −0.77 −0.41 −0.15 0.13 0.33

Panel C: Small Firm Sample: Double Sort

Low IV Alpha −0.35 −0.11 0.11 0.24 0.62

5. Profitability of Value Strategies Conditioned on Past Stock Price

Table VI. Tests of noise trader risk as a limit to arbitrage: 1963–2007

Intersection of Momentum and Book to Market Strategies for Small Stocks

Loser-Value Winner-Value Loser-Growth Winner-Growth

Average Excess Return 0.66 1.71 −0.28 0.87

quintile. As in earlier results, we report portfolio return characteristics including

6. Four Factor Premiums in Low Limits to Arbitrage Environments

Table VII. Low limits, zero cost portfolio regressions: 1963–2007

Alpha RMRF SMB HML MOM R2 OBS

Panel A: Small minus Large

Table VIII. High limits, zero cost portfolio regressions: 1963–2007

Alpha RMRF SMB HML MOM R2 OBS

Panel A: Small minus Large

negatively on MOM. There remains an unexplained alpha of 51 basis points with a

Behavioral explanations of financial anomalies encounter the objection that

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